Right in the Short Run

Yes, says Alex Tabarrok:

Here’s one idea which has got me thinking. In the debate over the economics of global warming the correct discount rate to apply to future generations is a key variable with those arguing that we should do something now, implicitly (and explicitly) arguing for a low discount rate. But if we count future generations highly we ought also to be in favor of reforming social security. Investing social security in the stock market “royally screws” current retirees but increasings the savings rate which will be benefit future generations. Thus, a low discount rate ought to weigh in favor of doing something about global warming and investing social security funds in the stock market. Not many people come out consistent on these grounds (I think Brad DeLong is one of the few.) I know, I don’t but Landsburg has got me thinking.

This is an interesting way to look at things. Some responses:

1. We should choose the reform that, on the margin, provides the most intergenerational benefit. Where global warming falls in this regard, I do not know, but Social Security is clearly swamped by Medicare in its long run shortfall.
2. Social Security reform only benefits current and future Americans, while fighting global warming benefits everyone.
3. There is, as Martin Weitzman calls it, a “left tail that carries most of the weight of expected marginal utility” to global warming outcomes in the absence of reform. We don’t know just how bad a world without global warming reforms will be in a century, but it could be very bad indeed. The distribution of marginal utility from an unreformed Social Security system is very tight and not particularly negative.
4. As for shirking on promises made to current Social Security recipients by investing cash that was destined for them into the stock market, then paying it out to future generations: doing so would royally screw anyone who was counting on Social Security for retirement. Future generations would not forget this sudden change, and would have to discount their SS payments by the likelihood of being screwed out of them — if it happened once it can happen again! This dynamic effect could swamp the benefit of screwing the current generation.

I believe reason 3 is why Tabarrok thinks Brad Delong is consistent. Check out Delong’s post, in which he reviews Martin Weitzman’s article.

Greg Mankiw and Robert Frank are going back and forth about one of Frank’s recent columns, in which he claimed that reducing marginal tax rates on the rich wouldn’t increase their work effort. I was reading through a review of the debate at Economist’s View and came across this statement by Greg Mankiw:

Bob is perfectly free to believe whatever he likes and to advocate increasing the top marginal tax rate. But to suggest that there is neither theory nor evidence to support the beneficial effects of lower marginal tax rates on high-income taxpayers indicates a lack of appreciation of the academic literature in public finance.

I will agree with Professor Mankiw here — lower marginal tax rates are definitely beneficial for high-income taxpayers!

To most economists, the answer to the question posed in this post’s title is simple: no.

That’s because economists view jobs as a quantity that is set in the labor market. For a given job, the number of people doing that job will be determined by the supply of labor and the demand of labor. Labor supply is how much labor everyone in the economy is willing to do at all the different wages imaginable, and labor demand is how much work employers in the economy want done for them at all the different wages imaginable.

At some wage rate, the number of people willing to work equals the amount of work employers want to supply. That’s called equilibrium, and the number of people willing to work at this wage will determine the number of jobs in the market.

When someone says that immigrants are doing jobs that Americans just won’t do, they are claiming that American labor supply for a given job is always zero. No matter the wage, no American is willing to get off his behind and do the work. I find it hard to believe that this could be the case for any kind of work, even if the task is extremely dangerous.

A slightly more interesting question is “Are there jobs Americans won’t do at certain wages?” Well the answer to this question is probably yes! Not too many Americans would mine coal for $4 an hour. On the other hand, some immigrants may well be willing to do the job at wages lower than any American’s. At low wages, there are plenty of jobs that immigrants will do that Americans won’t.

Just something to keep in mind when someone trots out the argument that immigration allows us to get jobs done that no domestic resident would be willing to do. Certainly there may be other benefits to immigration, but this is not one of them.

(See also Andrew Samwick)

In recitation tomorrow I’ll be teaching my students how the Fed’s monetary policy decisions work their way through the banking sector. As I thought about the material, I recalled an old passage from Paul Krugman’s classic, Peddling Prosperity:

Robert Bartley…describes the genesis of supply-side economics as taking place over a series of dinners at Michael I, a Wall Street area restaurant. There it was that he and [Arthur] Laffer discovered that Keynesian economics was logically inconsistent — an insight that had eluded Paul Samuelson and a few thousand other people over the course of hundreds of academic conferences. They also believed that Milton Friedman was wrong in believing that monetary policy could have important effects on the economy — an insight that had similarly eluded Friedman, Lucas, and the faculty of the University of Chicago over a generation of the notoriously brutal Chicago seminars. …

[T]he supply-siders did not believe that demand-side issues could matter. Bartley reports that Laffer educated him on the importance of Say’s Law, an eighteenth century dictum that says that supply creates its own demand. This was a rejection of Keynesian (and for that matter monetarist) economics on principle. Unfortunately, the principle is wrong: try telling the unhappy members of the babysitting co-op … that a general failure in demand is impossible. What happened there was that members of the co-op tried to spend part of their receipts of scrip, not on goods and services (baby-sitting), but on accumulating more scrip (money), which was impossible in the aggrgate, and therefore precipitated a miniature recession. But the Michael I diners thought they had neatly disposed of the whole topic of aggregate demand.

Second, the supply-siders dismissed the real-world importance of the money supply in general. Bartley tells of Laffer drawing a large box to represent the overall stock of credit in the economy, and a tiny box to represent that part of the stock corresponding to the money supply. “‘Do you really think,’ he asked, ‘this little black box controls all the others?’” Again, economists from Keynes to Lucas had spent a lot of time trying to explain just why it is that the monetary instruments controlled by the Federal Reserve exert a profound influence over the economy; but over dinner this work was found to be obviously wrong.

Hopefully tomorrow I will do a better job than Laffer and my students will understand how the money multiplier allows the little black box to have a lot of sway over all the others.

Mark Thoma has another extraordinary post at Economist’s View, this time taking on Bruce Bartlett’s claim that “hardly any economist believes what the Keynesians believed in the 1970s and most accept the basic ideas of supply-side economics.”

If you are looking for a quick primer on the two main schools of thought in Macroeconomics, I cannot recommend Professor Thoma’s post enough. Just scroll past the quoting of Bruce Bartlett’s article and look for the pretty charts. Some excerpts:

Real Business Cycle (RBC) theorists believe that most if not all fluctuations in the economy are due to supply side shocks, aggregate demand shocks such as changes in the money supply, changes in taxes, and changes in government spending affect nominal variables such as prices but have little to do with changes in output over time (however, government intervention does causes inefficiencies in these models so that less intervention is generally preferred to more). …

New Keynesians (NK) do not deny that shocks to aggregate supply can affect GDP nor that supply shocks can be large and important. However, New Keynesians also believe that aggregate demand shocks are important…

New Keynesians attempt to stabilize actual output around the natural rate as shown above. Why does NK policy tend to focus on demand shocks rather than supply shocks? The answer is that although it would be ideal if we could use supply-side polices to smooth short-run fluctuations in output arising from supply shocks, the reality is that we cannot do this. As Bartlett notes, supply-side polices are very blunt, slow-acting policies that can affect output in the long-run, but they are all but useless in dealing with short-run fluctuations in the economy (thus, RBC theorists tend to focus mainly long-run growth).

Since supply cannot be managed in the short-run, that leaves demand management policies, i.e. monetary and fiscal policy. …

For those who are already familiar with the tenets of New Keynesian and Real Business Cycle models, the post includes some political insight that’s also worth checking out.

Why do Republicans tend to endorse the RBC (real business cycle) framework? I believe in many cases that belief in the RBC model arises from an honest view that the evidence is most supportive of this class of models. But in other cases I believe it is an ideological marriage. The RBC model has two features that make it attractive.

First, because it says short-run stabilization policy is ineffective, and that government intervention through either spending or taxes generates economic distortions, the RBC framework supports an approach where the role of government in the economy is minimized.

Second, because the RBC framework allows for tax cuts to produce higher growth by reducing inefficiencies, and because it is then possible to argue that tax revenues might increase, it gives two reasons for supporting tax cuts - higher growth and less than a full loss of tax revenue, i.e. a dollar tax cut does not cost a dollar (or, for serious ideologues, the tax-cuts even pay for themselves).

The NK model, on the other hand, supports active government intervention which is at odds with this ideology. In addition, because the focus in NK models is on stabilization of output around the natural rate, not on growth of the natural rate, tax-cuts do not have the dynamic long-run effects as in RBC models (though these can be added) and hence there is not as much ideological support for tax cuts in the NK framework.

Check it out, and read through the comments to catch a glimpse of Paul Krugman butting heads with Bruce Bartlett.

There’s been a lot of talk about the South Korea free trade agreement lately on the ‘ol econ blogs. So before RISR gets left behind, I’m going to dive in with a little story about trade diversion.

Say country Alpha produces bikes for $10 each and country Beta produces bikes for $20 each. Country Gamma, the country in which you happen to live, doesn’t make bikes, but it does apply a $20 per bike tariff to bike imports. This isn’t so bad, you say, because in this world a Gamma citizen gets Alpha bikes for $30 and Beta bikes for $40. We should find these countries, you say, because on this Earth bikes cost $200! Well I haven’t said whether the bikes are any good, perhaps they are for teh tinies (teh childrens). But I digress.

In this world of uniform tariffs, assuming Alpha and Beta produce equally good bikes, Alpha will sell bikes to Gamma, and Beta will be left out. But what happens if Beta and Gamma sign a trade deal cutting all bilaterial tariffs on bikes to $0? Suddenly Beta bikes cost $20 and Alpha bikes cost $30. Gamma citizens only buy Beta bikes now, and they save $10 to boot! Free trade yay!

Unfortunately, the economists in Gamma are sulking in the corner. They say this trade deal wasn’t actually such a good deal — that it actually may have made the world as a whole worse off! What do they know?!

It turns out these economists are right. Alpha is the most efficient producer of bikes, and under the uniform tariff, it ended up being the main producer of bikes. With the bilateral trade deal, Beta became the exporter despite its relative inefficiency. Although the consumers of Gamma gained from the deal, it’s not clear whether this gain matched losses to the Gamma government — it no longer makes money off tariffs. As this example has shown, a country may start trading with a less efficient producer as the result of a trade deal, an outcome that economists call “trade diversion.” And trade diversion stinks.

One worry is that the American focus on bilateral trade deals has been trade-diverting. But don’t listen to me — talk to the experts! Here’s Mark Thoma:

What appears on the surface to be a series of free trade agreements betweent the U.S. and other countries is really a system of insider-outsider trade with all the distortions such preferential treatment brings about

Thoma quotes a new op-ed by Martin Wolf (check the Thoma link for the full text):

Why do I object? Is such trade liberalisation not precisely what most economists interested in trade believe in? The answer to this question is “yes and no”: yes, because liberal trade is desirable, but no, because this form of liberalisation is not necessarily a move towards liberal trade. As Jagdish Bhagwati of Columbia University has argued, “free trade agreements” should, instead, be called “preferential trade agreements”. I would prefer “discriminatory trade agreements”.

In this case, the US and South Korea agree to discriminate in favour of exporters or investors based in each other’s territory. The obvious potential economic cost of such an agreement is what Jacob Viner, the great inter-war trade economist, called “trade diversion”. In other words, the partners might shift from more competitive to less competitive suppliers. In this case, however, trade diversion may be modest, since these two countries are among the world’s most competitive suppliers of a wide range of goods and services.

A more significant economic cost, however, is systemic. The number of preferential trade agreements has exploded upwards in recent years… Other countries will be desperate to avoid the adverse effects upon them. This makes probable yet another jump in the prevalence of such agreements.

And Kash Mansori at The Street Light is pretty pissed too:

[T]he Doha Round (the round of multilateral trade negotiations that is intended to finally take serious steps toward helping the developing world) is “on life support” in no small measure because the Bush administration has never seriously tried to make it work, instead focusing on small bilateral agreements that make no difference to anyone in the US except for a few individual corporations. And there are good theoretical reasons to think that a bunch of small bilateral trade deals may actually make it harder to conduct multilateral trade negotiations, putting a world-wide level playing field further out of reach than ever before.

So yes, it’s not clear whether the South Korea free trade agreement was actually in our best interest. But don’t take my word for it…

As one of my professors once put it, Paul Krugman has an interesting mind. He has a knack for coming up with simple models that capture the essence of a phenomenon. One blogger from this site (who shall go unnamed, although it’s not me) says that personally hearing Krugman talk about one of these models inspired him to pursue economics in the first place. I can’t say I had a golden moment like that, but the elegance of Krugman’s explanations has strongly influenced the way that I look at economic problems. Oh, and I read his column religiously.

So on that note, I’m pasting an excerpt from a piece he wrote nearly a decade ago for the NY Times. In it he relates an old story about a babysitting co-op that experienced a recession. No, Krugman did not create this story on his own, but his prose tidies it up and gets down to the core cause of recessions.

Even baby-sitting can’t avoid recessions: Back in the early 1970s, a group of families in Washington formed a baby-sitting cooperative — that is, an arrangement under which couples would baby-sit for each other’s children. Such cooperatives are fairly common, but this one had two unusual features: It was bigger than most (containing about 150 couples), and two of its members, Joan and Richard Sweeney, not only understood what was happening but also wrote about it in an article entitled “Monetary Theory and the Great Capitol Hill Baby-Sitting Co-op Crisis.”

Such a co-op requires some system to ensure that members do their fair share. Like many co-ops, the Capitol Hill organization used a scrip system. New members were issued a certain number of coupons, each responding to one hour of baby-sitting time. When one couple watched another’s children, the baby sitters received the appropriate number of coupons from the baby sittees — coupons which the sitting couple would then “spend” on some other occasion.

What the co-op eventually discovered, however, was that this system worked only if there were neither too many nor too few coupons in circulation. Couples made decisions both about whether to baby-sit and whether to go out for the evening based on their reserves of coupons. If they had small reserves, couples were reluctant to use them up, preferring to save them for a rainy day; but they were quite willing to baby-sit to build up their hoard. If they had large reserves, they were eager to go out but reluctant to sit.

But one couple’s decision to go out was another’s opportunity to baby-sit, and vice versa. In the early days of the co-op, it turned out that there was too little scrip in circulation. that meant people were eager to baby-sit but reluctant to go out — which meant that many people who were willing to baby-sit could not find takers. And the realization that it was hard to find opportunities to replenish their coupons made people even more anxious to save their reserves for special occasions, which made opportunities to baby-sit even scarcer.

Eventually, the people who ran the co-op issued more coupons. The result was a dramatic improvement: More people went out, which meant coupons were easier to earn, which led to even more people going out, and so on. But then, inevitably, they overdid it. Once there were too many coupons in circulation, people became eager to go out, but it became hard to find baby sitters; as people realized that coupons often could not be used, they became even less willing to baby-sit in order to earn them.

What does all this have to do with the business cycle? the baby-sitting co-op was, in effect, a miniature macroeconomy; its problems were simplified versions of the problems faced by the U.S. economy as a whole. In particular, the downward spiral the co-op experienced when there were too few coupons in circulation was a recession — no more, no less. when America as a whole experiences a slump, the details are more complex, but the principle is the same. And Federal Reserve Chairman Alan Greenspan is simply the man who controls the number of coupons, otherwise known as the money supply.

That’s only an excerpt. Why not read the whole article if you’ve got the chance?

Once upon a time, Abhijit Banerjee (MIT), Angust Deaton (Princeton), Nora Lustig (UNDP), and Ken Rogoff (Harvard), together with a number of my favorite economists including Daron Acemoglu (MIT), Marianne Bertrand (Chicago), Peter Diamond (MIT), Esther Duflo (MIT), Michael Kremer (Harvard), and Chris Udry (Yale) got together and had a party!

What did they do at this party? Being nerdy genius academic types, they wrote a paper. Specifically, they evaluated World Bank research from 1998 to 2005. Here is an excerpt:

Bank researchers have also done extremely visible work on globalization, on aid effectiveness, and on growth and poverty In many ways they have been the leaders on these issues. But the panel had substantial criticisms of the way that this research was used to proselytize on behalf of Bank policy, often without taking a balanced view of the evidence, and without expressing appropriate skepticism. Internal research that was favorable to Bank positions was given great prominence, and unfavorable research ignored. There were similar criticisms of the Bank’s work on pensions, which produced a great deal that was useful, but where balance was lost in favor of advocacy. In these cases, we believe that there was a serious failure of the checks and balances that should separate advocacy and research.

While that passage is certainly not indicative of the overall findings of the committee, it is the juiciest. Perez Hilton would be proud.

In the first of a two-part post, we look at the reflections of NYU economist Debraj Ray about new developments in development economics, in this old paper from 2000. In the second part we will look at Abhijit Banerjee’s reflections on where development economics is headed as of 2007.

In recent years, the subject has made excellent use of economic theory, econometric methods, sociology, anthropology, political science and demography and has burgeoned into one of the liveliest areas of research in all the social sciences. And about time too: the study of economic development is probably the most challenging in all of economics, and provided we are patient about getting to “the bottom line” and the “policy implications”, it can have enormous payoffs.

The main trend I would like to try and document is a move — welcome, in my opinion — away from a traditional preoccupation with the notion of convergence. This is the basic notion that given certain parameters, say savings or fertility rates, economies inevitably move towards some steady state. If these parameters are the same across economies, then in the long run all economies converge to one another.

Ray then goes on to offer a number of theories that refute the conditional convergence hypothesis. These theories argue that “societies that are fundamentally similar in all respects might behave differently, and persistently so”.

Ray offers two reasons for his criticism of convergence theory. First, he contends that economies can exhibit multiple equilibria. “Simultaneously, such societies may display low savings rates or “cultures of corruption”, but this latter set of features cannot be related causally to the former.”

Second, Ray maintains that historical configurations may be important to development trajectories. In particular, two countries can face almost identical values of parameters relevant in growth models and yet proceed down strikingly distinct trajectories due to their differing initial conditions.

Of course what ultimately matters are the policy recommendations stemming from a theory of development. Ray’s theories promote one-time intervention policies that push the country into a new (and more desirable) equilibrium, while the old-guard convergence theories would require permanent shifts in relevant parameters.